April 30, 2018

First Quarter 2018: Investment Perspective

“Healthy correction” sounds like one of those expressions that deserves a special place in linguistic hell. Like “Congressional Ethics” and “Chocolate ‘Nilla Wafers”, it draws a nail down the chalkboard of our logical consciousness. If wealth accumulation is the critical mission, how can its rapid reversal be remotely healthy? For most investors, financial markets come in just two flavors – the upwards (good) kind and the downwards (bad) kind. However, for investors with a sufficiently long horizon, bull markets can be unhealthy and bear markets can be healthy. We examine why that awful oxymoron might actually make sense. Markets respond to two impulses – cash flow news and discount rate news. The cash flows are the future income stream, and the discount rate is the interest rate (adjusted for risk) that is used to determine the present value, or what that income stream is worth today. When that interest rate goes up, it means that the future payments are worth less today, so today’s asset prices fall. So far, so bad. But here’s the twist. If the future cash flows materialize just as they were forecast, the income in those future periods to investors has not changed. What has changed is that the compounded return will be higher going forward, since the lower current price combined with the same future payments has simply changed the returns earned, not the income. Imagine that you win this week’s Powerball lottery jackpot. The income stream will be about $4 million per year for the next thirty years. You might wonder what you’re worth today since you won the $122 million jackpot.

Unfortunately, the lottery operator will pay you $73.5 million today. That’s a discount rate of 3.6%. Since the state government municipal AA index currently yields 2.6%, I imagine that you can find someone to pay you over $80 million. And probably a few more will pay you still less than $73 million. How much you’re worth depends on who is discounting your cash flows, even though nothing changes about how much income you will receive.

Contrast that with news that impairs forecast income flows. If we are less well off in the future, then so are we poorer in the present. We simply start at a lower base of future income. The point of this comparison is that what truly matters to long-term investors is what they earn in the fullness of time. So, when markets gyrate up or down, the question that really matters is which variable changed – the discount rate or the cash flows. Usually both variables move at the same time, since new information about the state of the world shows up in both places. So it’s normally very tricky to disentangle the impacts. But this quarter was close to a laboratory experiment in finance. The value of the future earnings streams from global equities increased. The chart above shows the expected forward 12-month earnings in US dollars for the major regions, indexed to 100 one year ago. Earnings have increased 20% or more over the past year and are up high single digits year-to-date. Last year, interest rates were flat-to down, so the market discounted all of the good kind of information and had no countervailing force. As we moved into the first quarter of 2018, the earnings news continued to improve. However, this time interest rates increased. So those improving earnings had to struggle against a rising discount rate – and the discount rate won in the court of investor opinion.

In this quarter’s webcast, we discuss our perspective on the factors that drove the discount rate higher this quarter. Some of the sources of uncertainty that increased the discount rate pose low-probability and likely transitory risks. The issue that we expect to linger and perturb markets for the medium-term is inflation. As a result, we go into detail on the secular forces that are likely to determine the course of inflation. Our conclusion is that while discount rates have dented the current values of risk assets, the long-term income streams have not diminished. Perhaps ‘healthy correction’ – like Aunt Jemima Light continues to merit a place in our lexicon.

— Mark Hamilton, Chief Investment Officer

— T. Brad Conger, CFA, Deputy Chief Investment Officer

On a quarterly basis, Hirtle Callaghan publishes our perspective on the current market. If you would like to be added to our distribution list, please contact us.

Investment Perspective 1Q2018 excerpt.